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Year-End Strategy: Short the Small Caps Says Purves

Former Defense Secretary Donald Rumsfeld set off a linguistic slug fest 10 years ago when he gave his now famous ''known knowns'' answers about intelligence surrounding weapons of mass destruction in Iraq. While clearly rife for satire, Rumsfeld's statement has not only withstood criticism, but has actually become commonplace in certain financial circles on Wall Street. In fact, if you were to ask analysts to compile a list of things that are most nerve-wracking to investors right now, the election, the Fiscal Cliff, slowing earnings and economic growth would all be on it. They would also all fall into the known-knowns category.

It is for this reason, that the slightly bearish outlook of Michael Purves, the chief global strategist at Weeden & Co., caught my eye. Not only is he aware of the known knowns, but as he describes in the attached video, he's positioning himself to take advantage of them.

"Right now people would be well served to be hedged," Purves says, adding that "the near term risk is definitely to the downside here." As much as Friday's sell-off marked the first time in nearly four months that the benchmark indexes fell more than one percent in a single day, what stands out to Purves is how complacent markets have been.

On a day when Caterpillar (CAT) became the latest blue-chip, large cap company to give cautious guidance, Purves reacted to it as "a reconfirmation of the global GDP reset story" rather than some huge new development. But instead of shorting the large caps, Purves says the smarter way to is use small caps.

"In my mind the S&P 500 is not as good a hedging vehicle because of its high fortress companies, with strong balance sheets and strong dividends that act as sort of quasi bonds," he explains. But in the small caps ''you have a much lower dividend yield, higher financial leverage and higher economic leverage." He says when you add in the fact that 2013 earnings growth for the Russell 2000 is three times that of the S&P 500, it makes for a much better play.

To be fair, it's not like he's looking for a complete washout, but rather a fairly range bound market. More precisely, he expects perhaps another 3 to 4 percent decline in stocks, before firming up, albeit without taking out the previous highs for the year.